Active
approach
views the private sector as relatively unstable
and unable to recover from shocks. Economic fluctuations arise primarily from
the private sector, particularly investment. To move the economy to potential
output, the active approach calls for the use of discretionary fiscal policy.

Passive
approach
considers the private sector relatively stable.
When the economy gets off track, natural forces are enough to move it back on
course. Active government intervention is unnecessary, and can often do more
harm than good.

-wages
and prices are flexible enough to adjust within a reasonable period of time

-allow
natural forces to close the gap

Exhibit
1a and 1b (pg. 341)

b.Active
approach

-prices
and wages are not very flexible (particularly downwards)

-economy
will not quickly adjust, renegotiations of wages may take a long time

-the
longer the adjustment takes, the greater the economic and social costs of
reduced output and unemployment

-Use
active monetary or fiscal policies to close the gap.

One
cost of the policy is an increase in inflation. (There is a trade-off between
unemployment and inflation.) Another cost is possibly increased federal budget
deficit.

B.Closing an Expansionary Gap

a.Passive
Approach

-Natural
market forces will prompt firms and worker to negotiate higher wages. These
higher wages will increase production costs and shift SRAS to the left. This
leads to a higher price level and reduced output.

Graph
Exhibit 2 (pg. 343)

b.Active
Approach

-Advocates
view discretionary policy as a way to reduce output without inflation.

-The
active approach relies policy to decrease AD to close the expansionary gap.

-When
the Fed attempts to cool and overheated economy, it uses active monetary
policy to close the expansionary gap.

C.Problems
with Active Policy

1.Identifying
potential output and unemployment at that level.

2.Forecast
what AD and SRAS would be without intervention.

3.Must
have the tools to put the plan into effect relatively quickly.

4.Must
be able to predict the effect of the policy.

5.Policy
makers (Fed and Congress and President) must coordinate their actions.

6.Must
be able to implement policy even if it causes short-term political costs.

7.Must
be able to deal with lags.

D.The
Problem of Lags

Recognition lag  The time needed to
identify a macroeconomic problem and assess its seriousness

Decision-making
lag  The
time needed to decide what to do once a macroeconomic problem has been
identified

Implementation
lag  The
time needed to introduce a change in monetary or fiscal policy

Effectiveness
lag  The
time necessary for changes in monetary or fiscal policy to have an effect on
the economy

-Monetary
policy can take 3 to 6 months or 3 years to be effective.

-Fiscal
policy can take 3 to 6 months to show any effective and 9 to 18 months to have
full effect.

II.The Role of Expectations

The
effectiveness of government policy depends in part on what people expect.

Rational
expectations
 A school of thought that claims people form expectations based on all
available information, including the probably future actions of government
policy makers

A.Monetary Policy and
Expectations

Time-inconsistency
problem 
The problem that arises when policy makers have an incentive to announce one
policy to influence expectations but then pursue a different policy once those
expectations have been formed and acted upon

Example:

-Given
an economy producing at potential output, the Fed announces that it will pursue
a policy of price stability (keeping prices constant at the current level).

-Workers
negotiate and renew their contracts with that expectation.

-If
the Fed follows through, the price level will turn out as expected.

-After
workers and firms agree on wages, public officials (dissatisfied with the
current level of unemployment) persuade the Fed to stimulate AD.

One
solution to this problem is to take discretion away from policy maker so that
once a policy is announced, it cannot be changed.

Graph
Exhibit 3 (pg. 348)

B.Anticipation Monetary Policy

If
the Fed announces again that they will pursue a policy of price stabilization,
this time workers may not believe the news.

Example:

-The
Fed announces again that they will keep prices stable at a level of 142.

-Workers
expect the Fed to pursue expansionary policy and expect the price level to be
higher (152).

-Monetary
authorities must decide whether or not to follow their planned policy. Their
planned policy will result in recession. Only the expected expansionary policy
will result in the economy producing potential output.

-Monetary
authorities pursue the expansionary policy to avoid recession and this
reinforces the public's belief that the Fed will pursue expansionary policy no
matter what.

Economists
of the rational expectations school believe that if the economy is already
producing its potential output, an expansionary monetary policy, if fully and
correctly anticipated, will have no effect on output or employment.

C.Policy Credibility

For
the Fed to pursue a policy consistent with a constant price level, its
announcements must be credible.

Congress
cannot attempt to influence Fed policy by withholding funds because the Fed
earns a profit each year that is turned over to the treasury. So, although the
President appoints and the Senate approves members of the Board of Governors,
the Fed operates fairly independently.

When
central banks for 17 advanced industrial countries were from least independent
to most independent, inflation turned out to be lowest in the countries with
the most independent banks.

III.Policy Rules v. Discretion

The
passive approach often calls for predetermined rules to guide policy makers.
These rules take the form of automatic stabilizers aimed at offsetting the
effects of business fluctuations.

A.Rationale for Rules

The
economy is so complex and economic aggregates interact in such obscure ways and
with such varied lags that policy makers cannot comprehend what is going on
well enough to pursue an active monetary or fiscal policy.

Example:
According to Milton Friedman, although there is a link between money growth and
nominal GDP (direct channel- equation of exchange), the exact relationship is
hard to pin down because of long lags. To avoid the timing problem, he suggests
that the Fed follow a fixed growth rate monetary policy year after year.

B.Rules and Rational
Expectations

Proponents
of rational expectations advocate passive rules for a different reason. They
believe that people on average have a pretty good idea about how the economy
works and what to expect from government policy makers.

To
the extent that monetary policy is fully anticipated by workers and firms, it
has no effect on the level of output; it affects only the price level. They
advocate a monetary rule to avoid monetary surprises.